How to Avoid A Cryptocurrency Tax Audit in 2023

The IRS is growing more serious about cryptocurrency tax enforcement — which means it’s important to take steps to avoid a potential audit. 

By the time you finish reading, you’ll understand everything you need to know about how the audit process works (and minimize your odds of getting audited in the first place). 

Will the IRS audit you for crypto? 

Yes. If the IRS has reason to believe that you are underreporting your crypto taxes, it is possible that they will initiate an audit or send you a warning letter about your unpaid tax liability. 

What is IRS Operation Hidden Treasure? 

Operation Hidden Treasure is a partnership between the IRS’s Office of Financial Enforcement and Criminal Investigation Department created for the purpose of identifying underreported crypto income. 

In the past few years, the IRS has invested heavily in tools to trace and prevent cryptocurrency tax fraud. The IRS has also worked with contractors like Chainalysis to trace transactions and link ‘anonymous’ wallets to known investors. 

The agency has also issued John Doe Summons to exchanges like Coinbase and Kraken to request customer information.

Why would I be selected for an IRS audit? 

There are multiple reasons why you may have been selected for a cryptocurrency audit. Sometimes the answer is simply bad luck — your return may have been randomly selected through the IRS’s statistical formula. 

It is also possible that the IRS has reason to believe you are underreporting your cryptocurrency taxes or that you were conducting business with another party who is also being audited.  

What are the odds of a crypto tax audit? 

In general, the odds of an audit are relatively low. It was estimated that 0.63% of tax returns in 2023 were selected for an audit. However, the Inflation Reduction Act granted billions in new funding to the IRS — leading many experts to believe that more audits will be conducted in the years to come. 

It’s more common for taxpayers to be subject to an informal inquiry about underreported cryptocurrency taxes than a full-blown audit. For example, many taxpayers have in the past received CP2000 notices from the IRS about unpaid tax liabilities. 

Can the IRS identify my cryptocurrency transactions if I don’t report them? 

While cryptocurrency transactions are pseudo-anonymous, transactions on blockchains like Bitcoin and Ethereum are permanent and visible to the public. In the past, the IRS has worked with contractors like Chainalysis to link blockchain transactions to known individuals. 

Additionally, major exchanges like Coinbase and Kraken already report user information to the IRS. Tax reporting requirements are only set to grow more strict. In the future, all centralized exchanges will be required to send information on capital gains and losses to users and the IRS via Form 1099. 

How does a cryptocurrency tax audit work? 

How long a tax audit takes varies heavily depending on the specifics of your situation such as the complexity of your transaction history and the specific issues being discussed. There may be further rounds of questioning if the audit process reveals discrepancies in your tax filings. 

Typically, auditors look at financial records including your cryptocurrency trade history, bank account statements, credit card payments, loan payments, tuition costs, and insurance payments. If your costs are significantly higher than your reported income, the IRS may see it as a sign that you are hiding income.

Audit examiners may not have a deep understanding of cryptocurrency. However, the IRS does employ a team of behind-the-scene crypto experts to review documents and help guide the audit examiner through the process. 

When the audit examiner finishes the process, you will be given a letter explaining the IRS’s findings and assessing the amount you owe in taxes. You will be given 30 days to appeal the decision. 

If the IRS finds evidence that you may have committed tax fraud or tax evasion, they may refer your case to the Department of Justice. 

How to avoid a cryptocurrency audit 

Unfortunately, there is no way to completely eliminate the risk of a tax audit. However, there are steps you can take to minimize your likelihood of being selected for one. 

Accurately report your crypto earnings

Some of the crypto information that investors should report to avoid an audit include: 

• Your complete cryptocurrency transaction history 
• The accounting method used to calculate capital gains (FIFO, LIFO, or HIFO) 
• Any assumptions that are not represented within the data 
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Of course, accurately reporting crypto taxes is often easier said than done. Because crypto investors often use multiple exchanges and wallets, it can be difficult to find data on every buying and selling event. 

Cryptocurrency tax software like CoinLedger can help. The platform allows you to automatically import transactions from exchanges like Coinbase and blockchains like Ethereum. You can import all your transactions and generate an accurate tax return in minutes. 

Explain steep rises/falls in income 

A steep fall in income or a steep rise in expenses may look suspicious. Be sure to provide additional paperwork that explains such events in detail. 

Double check your tax return 

Remember, a simple mathematical mistake in your tax returns can increase your risk of being audited. If you have conducted a large number of cryptocurrency transactions, be sure to double check your calculations. 

Don’t over-report your home deductions 

If you’re running a cryptocurrency-based business such as a mining operation, you do have the option to deduct business-related expenses. However, it’s important to remember that claiming unusually large deductions in proportion to your income may draw the scrutiny of the IRS. 

In addition, we recommend keeping documentation of all associated expenses of running your business in case of an audit. 
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